Monday, December 7, 2020

Startup Cap Table 101: Reflecting a New Equity Financing

In the first blog post about cap tables, we talked about setting up equity compensation pools.  In this blog post, let's learn how to add a new equity investment to the cap table.  Let's assume that our startup has 2,000,000 founder shares outstanding, a 500,000 equity compensation pool, and a pre-money valuation of $1 million.  The investor is investing $200,000.

So, the cap table pre-financing looks like this:

                           Type of shares        # of shares        % fully diluted
Founder                Common                1,000,000            
Founder                Common                1,000,000
Pool                      Common                500,000
Total                                                    2,500,000            100%

To get the price per share that the investor will pay, we use the following formula:
pre-money valuation / # of shares outstanding, which in our case will be $1 million / 2.5 million shares = $0.40 per share.

Investor will own 16.7% of the company following its investment.  We get there by using the following formula: Investment amount / post-money valuation = % ownership, which in our case is $200,000 / $1,200,000 = 16.7% (BTW, post-money valuation equals pre-money + the amount of investment).

To find out the number of shares that the investor will get, we need to divide the investment amount by the price per share, which is $200,000 / $0.40 = 500,000 shares.

So, our new post-investment cap table looks like this:

                            Type of shares        # of shares        % fully diluted

Founder                Common                1,000,000            33.3%
Founder                Common                1,000,000            33.3%
Investor                Preferred                500,000               16.7%
Pool                      Common                500,000               16.7%
Total                                                    3,000,000            100%

We can get the same results by using different formulas.  Imagine that, as in the previous example, all you know is the following: (i) number of outstanding shares pre-financing, (ii) the startup pre-money valuation, and (iii) the amount of financing.  

                            Type of shares        # of shares        % fully diluted

Founder                Common                1,000,000            IV
Founder                Common                1,000,000            IV
Investor                Preferred                II                           16.7%
Pool                      Common                500,000               III
Total                                                    I                         100%

Using the known information, we can fill in the missing amounts.  We know that the investor will own 16.7% post financing by dividing $200,000 / $1.2 million post-money valuation.  

Let's solve for I:  We know that III+IV = 83.7%.  We also know that 83.7% equals 2,500,000 shares.  This means that I equals 3,000,000 shares (2,500,000 / 0.837).  

Let's solve for II:  If 100% equals 3,000,000 shares, then 16.7% will equal 500,000 shares.  Therefore, investor will receive 500,000 shares.  

Let's solve for III:  We can calculate III by dividing 500,000 shares by the total 3,000,000 shares.  

Let's solve for IV:  With the pool and investor shares taking 16.7% each, we have 66.6% left, split equally, to the two founders holding 2,000,000 shares.  This gives us 33.3% ownership for each founder.  

Since we know that a $200,000 investment buys 500,000 shares, then the price per share will be $0.40.

Although some numbers may be somewhat off due to rounding errors, the formulas should work.  

Next, time, let's see how to reflect the conversion of convertible notes at the time of the financing.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.

Wednesday, December 2, 2020

Startup Cap Table 101: Introducing an Equity Compensation Pool

 I have to admit: cap table calculations are not easy and not all startup lawyers enjoy this part of their jobs.  However, no matter how hard it can get, being able to make sense of the cap table is an essential skill for startup lawyers.  Since I have just finished teaching this to students at Fordham Law's Entrepreneurial Law class, I thought I would share some of the calculations here with you.  

Let's start with your basic cap table:

                            Stock Type        Shares        Fully Diluted Stock %
Founder A            Common        1,000,000        50%
Founder B            Common        1,000,000        50%
Totals:                                         2,000,000       100%    

This example shows that the startup has two founders, each holding 50% of the issued and outstanding stock.  BTW, this startup has authorized 5,000,000 shares of common stock, $0.00001 par value.

The Board of Directors has just approved the issuance of an equity compensation pool of 20%.  The stockholders of the company (ie, both founders) have also unanimously approved the pool.  Now, let's reflect it in the cap table:

First, let's find out how many shares will be allocated to the pool.  To get there, we use the following formula: 

Total New Shares Outstanding = Existing shares outstanding / 1 - options pool %, which means: 2,000,000 shares / 0.8 = 2,500,000 shares.  So, with the pool, the startup will have 2,500,000, which means that the pool will have 500,000 shares of common stock allocated to it.  Our cap table now looks like this:

                            Stock Type        Shares        Fully Diluted Stock %
Founder A            Common        1,000,000        40%
Founder B            Common        1,000,000        40%
Pool                      Common        500,000           20%
Totals:                                         2,500,000       100%    

As you can see, the creation of the pool diluted both founders.  Obviously, if the pool were to be created after an equity financing event, it would dilute both the investors and the founders.  That's why investors always want the pool shares to be created on a pre-money basis, diluting the founders alone.  

In the next blog post, let's look at how to add a Series A financing to this cap table.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.

Sunday, November 29, 2020

The SEC Modernizes US Securities Laws – Part I – Amendments to the “Accredited Investor” Definition

This Fall 2020 has seen an unprecedented number of rulemaking by the Securities and Exchange Commission (the “SEC”) that will be remembered for years to come.  I will attempt to summarize the changes for you in a series of blog posts.  Altogether, the changes will have lasting ramifications for the U.S. capital markets, enabling (I predict) an even greater flow of capital to the private markets.  The changes come at an important time when, due to the pandemic, many have lost jobs and may be launching their own ventures.

Below are the notable changes:

1. A revised definition of “accredited investor”;

2. Introducing two exemptions for finders;

3. Proposing changes to Rule 701 enabling to issue equity to the participants in the gig economy;

4. Adopting sweeping changes to Regulation CF; and

5. Rule amendments to Regulation A+, integration, and other rules.

Today, I will focus on the amendments to the “accredited investor” definition.  Subsequent blogs will cover the remaining rulemaking.  

On August 26, 2020, the SEC published its final rules amending the “accredited investor” definition.  These rules become effective on December 8, 2020.  The definition of accredited investor is the cornerstone of private placements made pursuant to Regulation D and has not been substantially amended since its adoption in 1982 (except for the 2011 amendment excluding the value of the primary residence from the net worth test).  Regulation D is the most relied upon exemption from registration requirements of the Securities Act for private placements of securities in the United States.  According to the final rules, in 2019, out of $3.9 trillion raised by companies in the United States, Regulation D private placements accounted for $1.56 trillion.  

Regulation D consists of Rule 504 (not frequently used) and Rules 506(b) and 506(c).  Rule 506(b) allows issuers to offer and sell securities to an unlimited number of accredited investors and up to 35 non-accredited but financially sophisticated investors (although from 2009 to 2019, only between 3.4% and 6.9% of all Rule 506(b) offerings included non-accredited investors).  Another popular rule within Regulation D, Rule 506(c), allows sales only to accredited investors.  Therefore, being an accredited investor is essential for being able to participate in the private placements of securities by startups, which could at times be extremely lucrative.  

Prior to the changes, the status of accredited investor, as applied to individuals, was determined based on such person’s wealth, with wealth being the only proxy for financial sophistication.  The SEC estimates that approximately 13% of the U.S. households currently meet the wealth-based accredited investor tests.  The final rules expand the definition by adding to the list of accredited investors those who hold certain professional degrees and are in good standing: the Licensed General Securities Representative (Series 7), Licensed Investment Adviser Representative (Series 65), and Licensed Private Securities Offerings Representative (Series 82).  This list is subject to ongoing revision by the SEC based on the nonexclusive list of attributes that the SEC will consider in determining additional qualifying professional certifications.  Although there are over 700,000 individuals who are currently Registered Securities Representatives and State Registered Investment Adviser Representatives, it is unlikely that the universe of qualifying investors will increase by that same number, given that some of these individuals may already qualify under the wealth tests.  Even though this change will not have a significant effect on the number of qualifying individuals, it signals a change in the overall approach towards defining who accredited investors are.

Another new category of individuals who are now accredited investors are the “knowledgeable employees” of “private funds” (private equity or hedge funds that are investment companies but qualify for Section 3(c)(1) or 3(c)(7) exemptions).  The term “knowledgeable employees” is already defined in Rule 3c-5(a)(4) under the Investment Company Act.  Starting on December 8, 2020, such employees can participate in the private fund’s investments as limited partners.  Making such individuals be accredited investors for the purpose of investing in the private fund for which they work (or are affiliated with) is reasonable and helps align their interests with the interests of the other limited partners.  

The SEC has also added several categories of entities to the list of accredited investors:

any investment adviser registered under federal or state law (and Exempt Reporting Advisers relying on Section 203(m) or 203(l) of the Investment Advisers Act of 1940) – this also applies to sole proprietorships;

any rural business investment company (RBIC);

any entity that owns investments in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;

any family office with at least $5 million in assets under management and that was not formed for the specific purpose of acquiring the securities offered, and whose investment is directed by a person capable of evaluating the merits and risks of the prospective investment; and

any family client of a family office described above whose prospective investment is directed by that family office.

The SEC also clarified that limited liability companies with $5 million in assets and not formed for the specific purpose of acquiring the securities offered qualify as accredited investors.

Lastly, the SEC allowed natural persons to include joint income and net worth from spousal equivalents when calculating the wealth-based tests.  “Spousal equivalent” is defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.  

Here is a helpful blackline prepared by Pillsbury that shows the changes to the definition of accredited investor.

In conclusion, the amendments to the definition of accredited investor will significantly increase the pool of qualifying investors, although mostly among entities rather than individual investors.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.